發現金融 (DFS) 2007 Q3 法說會逐字稿

Good day, ladies and gentlemen and welcome to the Q3 2007 Discover Financial Services Earnings Conference Call.

My name is Mike, I'll be your operator today.

At this time, all participants are in a listen-only mode and we will be taking questions at the end of today's presentation.

(OPERATOR INSTRUCTIONS) .

As a reminder, ladies and gentlemen, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today's call, Craig Stream, Vice President of Investor Relations.

Please

Thank you, Mike.

Good morning, everyone.

I want to welcome all of you to this morning's conference call.

We appreciate your joining us for today's discussion, and we look forward to maintaining open and responsive communication with the investment community.

My role this morning is to remind everyone that the discussion today contains certain forward-looking statements about the Company's future financial performance and business prospects which are subject to risks and uncertainties and speak only as of today.

Factors that could cause actual results to differ materially from these forward-looking statements are set forth within today's earnings press release which was furnished to the SEC in an 8-K Report and in the Company's Registration Statement on Form 10, already on file with the Securities and Exchange Commission.

In the third-quarter 2007 earnings release and supplement, which are now posted on our web site at DiscoverFinancial.com and have been furnished to the SEC, we have provided information that compares and reconciles the Company's managed basis financial measures with the GAAP financial information and we explain why these presentations are useful to management and to investors.

We urge you to review that information in conjunction with today's discussion.

Our call this morning will include formal remarks from David Nelms our Chief Executive Officer, and Roy Guthrie, our Chief Financial Officer, and of course a question-and-answer session.

Now it's my pleasure to turn the call over to David Nelms.

Thanks, Craig.

I want to add my welcome to all of you this morning.

This is our first quarterly earnings call since becoming an independent, publicly owned company, and we are very excited to be reporting to you today on our results for the quarter.

During our spinoff road show, which seems a lot longer ago than just mid-June, we were frequently asked why we were starting out with so much capital and liquidity.

We stressed that it was essential for us as a newly public entity to emerge with a very strong capital base and liquidity position.

On the other hand, we got very few questions at that time about credit risk given our strong recent performance.

With the recent turmoil created by the subprime mortgage problems, it's clear that we made the right call to focus on establishing a strong liquidity and credit quality foundation.

In fact, we have taken further steps to strengthen our liquidity position since the time of the spinoff, and despite some indications that delinquency rates may rise in the future, our credit performance continues to be outstanding.

We are continuing to generate consistent growth in our lending business, while maintaining a tight focus on controlling credit risk.

The funding environment changed dramatically during the quarter but is showing signs of improvement following recent actions by the Fed.

We have taken a number of important steps in response to the changes in the funding environment, and Roy will have more to say about that a bit later.

Overall, we were quite pleased with our performance this quarter and continue to be very confident about business trends and capital generation going forward.

In fact, this morning, we were happy to announce that our Discovery Board of Directors declared their first quarterly cash dividend of $0.06 per share.

I'm also very proud of the high quality Board of Directors we have assembled including the most recent last week of Michael Mosko former President and Chief Executive Officer of the Federal Reserve Bank of Chicago.

Roy will take you through our results for the quarter in greater detail, but I'd like to make just a few comments.

Our U.S.

Card business turned in solid consistent growth in receivables with absolutely superb credit performance.

In fact our U.S.

loan loss rate of 3.7%, was below that of the second quarter, and our 30-plus delinquency rate was only modestly higher than the record low we achieved in May.

We have made it clear that increasing merchant acceptance in the U.S.

is a very high priority, and I'd like to give you an update on our progress since the spinoff.

As you recall, we have adopted a hybrid strategy where we will retain direct relationships with the larger merchants and will work with merchants acquires to reach small to mid--sized merchants.

At the time of the spinoff we had agreements in place with acquires representing over 50% of the industry sales volume.

We recently announced agreements with Chase Payment Tech Solutions, Wells Fargo Merchant Services, and Bank of America Merchant Services, so we now have acquiring agreements in place with firms representing over 90% of the U.S.

Industry sales volume.

We will continue to focus on implementation of our new acceptance strategy through this year and throughout 2008.

Moving on, we are very pleased that we are achieving accelerated transactions growth in our Third-Party Payment segment.

Increasing to 17% year-over-year growth.

During the quarter, we signed a number of important, Third-Party Issuer contracts, primarily for Debit Card Network Services.

On the other hand, we are not satisfied with the losses that we continued to sustain in our UK business.

We are in the midst of a very challenging operating environment there, and this quarter's loss was further magnified by spin-related effects and reserve additions.

We are taking actions on a variety of fronts to drive incremental revenue and reduce costs and expect to see the impact of these actions later this year and particularly in 2008.

Now let me turn the call over to Roy Guthrie for some detailed comments.

Okay.

Thanks, David.

Let's just go straight to the results.

First of all, after-tax income, $202 million, $0.42 a share.

And that compares to $241 million in last year's third quarter.

And I think as we discussed during the road show and you'll hear this dramatically through my remarks, comparison to last year is going to be a little bit difficult given last year's benefits from the bankruptcy spike in 2005, and the fact that this year we're incurring spend-related costs.

So I'll take a moment really now to cover each segment beginning with the U.S.

Card-Issuing business.

And as you heard David say, looking at a couple of key performance indicators there, 5% year-over-year receivables growth clearly coming in with our target range that we've indicated between 4% and 8%, and I think really appropriately conservative in the kind of environment that we're in right now.

This was our sixth consecutive quarter of sequential organic loan growth, so we're very pleased with that trend.

Credit quality, I think, continues to be very sound.

U.S.

Charge-Offs, you heard David cite this number, 3.7%.

A sequential decline of 30 basis points.

And a 30-day delinquency rate, 316, 3.16%.

Up 19 basis points, but it's coming off of the all-time record low for Discover in the second quarter this year.

And we see that principally in the older back-end delinquency bucket but we feel very, very strongly about the quality of our underlying portfolio.

I think importantly we continue to focus on lending into the prime credit segments.

I think we emphasized this when we first got to know you all during the road show, and I'd like to introduce a few statistics here that I think help bring some color to that.

The average FICO score of all accounts originated this year is 736.

And that's not just this year, it's very consistent with the average of accounts booked over the last four years, which has ranged between 734 and 738.

In addition, I think we pointed out previously and I'll reiterate that at this quarter end, the balances for accounts booked the year with FICO scores less than 660 was just at 3%.

We're not seeing any meaningful signs of deterioration in credit performance.

Statistics speak for themselves, and I think this is a somewhat of reflection of the possible attribution to the subprime mortgage situation.

Clearly national bankruptcy filings continue to run reasonably stable but rising at 15,000 to 16,000 per week, 30% above a year ago, but still well below the 2005, pre-spike levels.

The increase that we see in delinquency that just was cited and these bankruptcy trends suggests that there's going to be moderate growth in our charge-off for fourth quarter.

For some time now we've been anticipating some measure of an economic downturn, resulting in clearly rising unemployment, and we've been preparing for this by tuning our customer acquisition and line management strategies.

We've also heavily invested in upgrading the talent, the analytic tools, clearly the risk management environment that we have we believe is well prepared for potential economic downturn.

In addition, we've done a fair amount of work to understand this mortgage situation and how it results our cardholders.

As a result we've taken steps I think to prepare the control environment that we operate in for a potential turn in credit performance and as adverse credit trends emerge we would expect our business model to incorporate those adjustments necessary to make room for those higher charge-offs and maintain a targeted level of profitability that we've cited as we become public.

Taking a look at the income statement now, U.S.

Card segment earnings were $387 million.

Net interest income was up year-over-year of $35 million or 4% .

That's really despite significantly higher interest expense we saw in the quarter including those post-spin funding impacts.

Average domestic receivables up 6%.

Seeing obviously margin up 4%.

We've had slight compression, very slight compression in our margins falling from 796 a year ago to 784 this quarter.

But very stable, up 6 basis points from the prior quarter.

The overall provision for losses was essentially flats year-over-year.

But did include higher charge-offs in this year versus last year.

As we've seen that normalization from the post-bankruptcy spike.

And that was offset by a post reserve release in the U.S.

this year of $15 million, reflecting lower on-balance sheet receivables versus the prior quarter.

Other income was down $30 million year-over-year due to higher securitizations in 2006.

And the resulting gains that we posted resulting from that, and as you recall, we've cited that during 2005 we were temporarily out of the securitization market, so '06 had a disproportionately high volume of acid back securitization that we're now looking back on.

Our Third-Party Payment segment achieved transaction growth of 17%.

That's ahead of that 15% target we've set.

And our Pulse business had a terrific performance , was up 26%.

This segment which includes, both Pulse and Third-Party Issuer business remains a relatively small contributor to profits.

You saw that on the release, $9 million pre-tax for the quarter.

But a very important part of our future.

And we have continued to add new financial institution partners.

And renewed existing relationships, and that gives us confidence in the future outlook for our payments business.

The significant growth in partnerships has a dampening effect on current period revenue as we sign those in the segment really has I think a tremendous amount of investment going on in it.

And incentives paid to new partners do have a dampening effect.

However, I would note that despite the significant transaction growth, the expense base has been fairly flat, and that does reflect I think a couple of the key attributes of this business.

Fixed costs and scaled benefits.

Our International Card segment incurred a pre-tax loss of $67 million in the quarter.

As our efforts to turn this business around continue to be affected by a very difficult operating environment and some additional factors that I'll cite here.

Loan losses and delinquency rate remain high, but do appear to be stabilizing.

And I'd cite a couple of things.

First of all, year-over-year we have seen 90-plus delinquency rise 21 basis points.

But we've seen now the last three sequential quarters some signs of stabilization in that measure.

Going forward, we expect to see our UK Credit performance to generally follow the trends in the overall market which at the present is somewhat uncertain given mixed signals that we see, including some moderation in bankruptcy filings as an industry, but potentially offset by concerns over high consumer indebtedness and a situation in the housing market in the UK.

We're now experiencing a higher cost of funds in the UK.

This reflects a number of things including a base rate increase, a loss of our Morgan Stanley funding over there, which was disproportionately high, an elevated cost in our Conduit Financing Solutions that we've put in place at the spin date.

Disruptions in the UK Financial markets and higher interest rates have also impacted ABS Issuance, leading us to retain during the quarter on balance sheet about $500 million of receivables from a maturing asset-back transaction.

So as a result during the third quarter, we added about $17 million to our credit loss reserves in the UK business reflecting the fact that those assets now have moved back on our books.

As you know this is a non-cash impact and should the UK market for acid-backed securities open up again, we may very well then in turn resecuritize these receivables and see these trends in the P&L reverse themselves.

I would say that I don't expect to see that occur before the next year.

Certainly not in the fourth quarter.

We're taking actions in the UK on a number of fronts, to mitigate the effects of these environmental issues including cost-reduction efforts, modes to the modifications to our rewards program, certain targeted pricing actions.

And I think it's important to note that we also expect to see receivables shrink as we focus on improving profitability.

We saw that in the third quarter as we saw sequential quarter liquidation.

So turning a risk business around is not going to be quick or easy, but we do have very specific plans targeting different areas of the business, and I think we're on path to improve our results.

Moving on to operating expense, we're continuing to put heavy focus on this.

While in turn investing for future growth.

Excluding marketing, non-interest expense was down $2 million year-over-year.

Add that also in a sequential quarter basis non-interest expense excluding marketing declined $27 million.

But that clearly included some reductions in spin-related professional fees in both our US and UK segments.

As we laid out last quarter, we would expect this year's full-year marketing spend to be in the same range as last year, and we really see no reason to change that view at this point.

We also estimated about $30 million of spin-related cost in the second half of which as you can see in the release we've incurred $9 million here in the third quarter.

So more than likely not see the full $30 million be required.

And I would suggest that fourth-quarter spin-related expenses would be approximately what we've seen here incurred in the third quarter.

Let me briefly comment on the effective tax rate which came in at $38.6% for the quarter, somewhat hire than you might of expected.

I think the increase results primarily from non-deductible spin-related cost that hit in the quarter.

And some of those may be incurred in the fourth quarter, as well.

So as you think about the fourth quarter and the comparison to last year, I just want to remind you of a couple of things.

Principally, these effects of non-deductible spend costs, but also last year's fourth quarter which had a negative tax rate because of the impact we had from a couple of favorable tax settlements that both hit that quarter.

Before we go to Q&A, I want to spend a couple of minutes talking about liquidity.

And I think during the road show we spent a fair amount of time outlining the overall liquidity structure of Discover.

I think it's worthwhile at this point to update you on the progress that we've made in building out that targeted position.

And the changes that we've made as a result of the present environment we see ourselves in.

Our primary day-to-day short-term pool of liquidity consists of cash or, high-grade, short-term marketable securities, more bank deposits, Fed Funds sold.

We had targeted around $5 billion of cash as of the spin-off, which was in position at the end of June.

However, given the signals that we are getting with regard to the market, we began to move ahead in July and August to bolster that position.

And at the end of August, or quarter's end, we held over $8 billion of cash liquidity on the balance sheet.

A pretty significant movement.

We'll most likely continue to maintain this elevated level of cash liquidity on the balance sheet until we get a better sense as to when we will see more normalized market conditions return.

The additional liquidity has been built using principle our bank deposit programs, the weight average duration of those deposits over two-years so I think a very solid underpinning.

The bank deposit markets have really served us well during these difficult global capital markets.

Period our balanced funding capabilities that we've talked to you about while on the road and the strong capital position that we came out with has clearly permitted us to not only sustain but push liquidity higher during these very difficult times.

To bolster our deposit programs during the quarter, we've also expanded the group of distributors for both our Money Market-Insured term and term Certificates of Deposits, Money Markets now distributed through three providers and CDs sourced through five providers, so very good market coverage in that regard.

We also came public with $2.4 billion of open capacity with Financial Partner Conduit, of which during the quarter we used $500 million.

So as of the end of the quarter, we had $1.9 billion in additional open capacity in these conduits.

Turning to the capital markets in June, we completed the transition of the Discover Master Trust to its improved dealing structure referred to as DESCENT in the market.

And at the end of the third quarter we have just over $700 million of subordinated issuance which is sufficient to create in that program $5 billion of Triple-A capacity.

That's as of quarter end.

We've seen very little credit card ABS issuance in the last few weeks.

And clearly the issuance that has cleared the market has been at significantly wider spreads.

Both relative to historical ABS spreads and relative to the current alternative deposit cost that we see in the market.

Given our level of balance sheet liquidity and access to alternative markets, we'll continue to carefully monitor these U.S.

Capital markets and the pricing within them to time our next deal very carefully.

Finally, I'd like to add that we did close our bank revolver just after the spin.

That wasn't in place as of June.

That created a five-year, $2.5 billion facility which is comprised of over 20 banks and is in place at the present time.

And we regard that as a source of contingent liquidity.

Adding it all up, the cash, committed conduit capacity, and the bank revolver, we closed August with just over $12 billion of liquidity.

And when you include the Triple-A capacity in the trust, just over $17 billion of liquidity.

While the liquidity is in place, the debt markets during the third quarter created slightly higher levels of interest expense than we had expected.

As we saw for example, US LIBOR GAAP up from the historical Fed Funds spread.

This is going to create higher interest expense on the ABS programs as we like many other programs in the market reset our pricing against one-month LIBOR around the mid-month period.

And both our August and September resets were elevated.

So we're going to have some margin compression here.

In addition, conduits generally priced on a cost-plus basis, and their costs were elevated certainly in August and will remain so in my view through the fourth quarter.

Lastly, our growing investment pool I'd cited earlier has been directed toward bank deposits and high grade industrial and Financial CP.

And given the strong bid on quality in the market, we've seen a bit of a lower return on these funds.

So these three impacts affected our results somewhat, I think, in the third quarter.

I would add disproportionately so in the UK.

And will continue in the fourth quarter until we see things settle down.

I'm estimating the overall impact to be approximately 20 to 25 basis points of spread compression while these forces are in place.

Clearly the rate reduction by the Fed last week should ultimately help, but I think what we need to see is sustained return to the historical relationship or the spreads between LIBOR and Fed Funds to fully eliminate this margin impact.

Now let me turn the call back over to David for some

Thanks, Roy.

In closing, I'd like to say a little bit more about the outlook for the business.

In the US, employment levels, consumer spending, and unsecured credit quality continue to hold up well, and we are enjoying the benefits of those factors in our business.

On the other hand, there is uncertainty in the economic outlook because of the mortgage and housing situation.

In the face of this uncertainty, we remain focused on the targets we previously articulated.

Growth in US card receivables of 4% to 8%, while maintaining a tight focus on credit.

A continued push for growth in our payments businesses, an improved profitability in our international business.

At the same time, we will tightly control non-interest expenses so that we can achieve our earnings goals while maintaining the flexibility to invest for long-term growth.

Now we would be pleased to take your questions.

Thank you, sir.

(OPERATOR INSTRUCTIONS) .

And the first question comes from the line of Howard Shapiro with Fox Pitt.

Please

Hi.

Thank you very much.

And congratulations on your first quarter as an independent company.

I wanted to just follow up on what you had said about fine-tuning your customer acquisitions in light of a potentially deteriorating consumer economy and your attempts to kind of understand the implications of the mortgage meltdown on your business.

Could you give us some more detail on what you're actually doing in terms of acquisitions and understanding the mortgage market implications in terms of underwriting, what it might mean for growth and credit?

Thank you, Howard.

First, on acquisitions to a large degree, it's maintaining our current focus on the prime customers.

And I think the FICO score information that we outlined to you today is indicative of the fact that -- that while we -- while we have been achieving accelerated growth in our renewed -- renewed growth in our business over the last 18 months, that that has not come at the cost of our credit standards.

And in fact we continue to have very attractive and high FICO score customers coming in.

In terms of other things we've prepared, I think over the past three years, we have significantly strengthened our collection abilities.

We do collect accounts in house.

So we feel we have tighter control.

We've put in new systems.

And we have also strengthened our underwriting, credit line management, as one example.

We have a unit that actually calls customers before they even have gone delinquent to help ensure that they stay current on their accounts.

And that's been very effective.

We have looked closely in our file at people who have mortgages and specifically mortgages who may be resetting.

And -- and we continue to look for signs of stress from some of those customers, but it's a relatively modest part of our portfolio.

And we haven't seen -- we've seen surprisingly little stress move over into our credit card portfolio so far.

Would it be fair to say that you've maybe dialed back or restrained your growth a little bit just to be cautious in the -- in advance of a declining credit, or would that not be accurate?

Well, I think when we set the 4% to 8% range and the fact that we've maintained a pretty consistent 5% year-over-year growth for six quarters now suggests that we've -- we've kept what we think is the appropriate growth level given both the opportunities but also the potential for more difficult credit times in the future.

Okay.

Thank you very much.

The next question comes from the line of Darren Peler with Lehman Brothers.

Please proceed.

Thanks, guys.

Just starting off on capital allocations, just curious to hear your thoughts on the forward outlook on your capital plans.

Now I think you start off on the road show with discussing 48% receivables growth.

And assuming you maintain your capital ratios you could still have in excess somewhere of roughly 4 to $500 million on top of the dividend payout assuming that's annualized.

Can you give us a sense for your thoughts, if there could be more dividend increases to come or buybacks?

Darren, it's Roy.

Yes, I think that's-- our views haven't changed over the last early I guess two months since we were out on the road talking about this.

We clearly see return targets for the business well in excess of what we think are core balance sheet requirements are going to be.

Clearly we want to make sure that we continue to allocate initially adequate capital not just to the balance sheet aspects of the business but to all segments to make sure that they're achieving their strategic plans.

We had cited the fact that we had a number of other things beyond that which would include cushions associated with deploying capital against possible organic opportunities to grow as well as dividends, and then I think as a residual of the potential that we could then begin to execute stock buyback programs.

So that sort of cadence or waterfall, whatever you want to call that sort of sequence, that thinking is still very much in place.

Clearly we've seen the balance sheet continue to grow.

We've seen the capital form faster than that.

We've now come out and announced this dividend.

We're very pleased to have that part of the plan in the public domain.

And as I think time progresses, you will probably see to the extent there is additional capital that gets warehoused or stored on our balance sheet or other measures including the potential for stock buybacks being introduced to deploy that.

Great.

Thanks.

Real quick also on your merchant acquisitions, the relationships with Chase and Wells, the -- I think they said 600,000 relationships that Chase has around 260 that Wells has, what kind or is there any overlap between what you have in terms of the merchants versus the new ones that are added?

Certainly there's overlap.

And we've estimated that about 77% of small and mid-sized merchants currently accept Discover.

And so we -- we will be gaining some efficiencies by moving to consolidated statements and processing for that overlap.

But for us, the bigger gain is the roughly 23% across all acquires that didn't previously accept Discover.

We will be expecting these acquires to basically turn on Discover and include Discover with new Visa/Master Card signings as we roll that out.

You know, it's going to take some time.

We'll be rolling this out through 2008.

Okay.

Then is the interchange on these relationship higher than the previously interchange levels?

In the past, we accepted the merchant discounts, had internal expenses, and in the new model for small and mid-sized merchants, we've moved to an interchange level and we've established an interchange level that I would say is in -- is roughly similar to that of Visa and Master Card so that our economics will be similar to Visa and Master Card issuer.

Okay.

Great, thanks.

And our next question comes from the line of Ken Posner with Morgan Stanley.

Please proceed.

Good morning.

I wanted to ask a question if I could about the UK business.

And if I read the press release properly, there was a $67 million loss of which $17 million was the reserve issue, and there was also $4 million in spin expenses.

So if we take a $46 million loss, is there a credible game plan to get that $46 million loss to a positive number that would be an acceptable return consistent what the -- the other operators in the UK are achieving?

Well, first, Ken, I would say that most operators in the UK are experiencing some level of stress related to charge-offs, elevated funding costs, and downward pricing pressures.

However, we have a plan to significantly reduce the loss next year.

And we have numerous steps on the cost, revenue, and business management side to achieve that.

But it -- we have not yet forecast when we will get first the profitability and then ultimately to an acceptable return.

We are very focused on it.

Thank you.

And the next question comes from the line of Sanjay Sakhrani from KBW.

Please proceed.

Thanks.

Just a quick clarification from the international side.

From this point onward, understanding that credit is in flux, but what should we expect on a go forward ahead basis?

Should we expect improvement from the third quarter onwards?

And you mentioned sort of, Dave, getting better profitability into next year.

Is that break even by next year?

I think for the full year, we expect a significantly reduced sloth but we are not forecast a break even or for profit for the full year.

In terms of the business itself, we are dealing right now with some higher funding costs as Roy outlined which will put further pressure in -- in the fourth quarter at a minimum.

But as I said, we have significant actions to improvement one of the things we are doing is shrinking to a core that is more profitable.

So we do expect as Roy mentioned some decline in receivables as we focus on profitability versus growth.

Okay.

Then I guess just a quick question on the revaluation of the IO Strip in the U.S.

Card segment.

What actually drove that?

That's a good question, Sanjay.

And as you know or maybe not, let me articulate briefly.

What you do -- it's a mark and a look-forward mark.

And the principal reason why we saw that sort of come out of an area where you wouldn't have expected it is the elevated level of interest expense in our U.S.

business that I articulated in my prepared remarks.

That mark is looking forward into the fourth quarter and sees if I will our expectation for these higher interest charges and takes that in the form of a balance sheets charge to write down the IO.

Remember, of course, that the -- you're looking at trust assets, and trust assets do reset off of LIBOR.

And again, just echoing what I said, LIBOR's reset was elevated in August/September.

We're expecting that to continue into November.

But the LIBOR's come in, right?

LIBOR's come in, but the relative spread between LIBOR and prime has not.

Okay.

I got it.

Great.

And I guess just one last question on the spinoff cost.

Which line on the expense -- which expense line were they on?

Well, they -- they principally show up on the professional fees to a lesser extent in other expenses.

Okay.

Great.

Thank you.

And the next question comes from the line of Eric Wasserstrom with UBS.

Please proceed.

Thanks.

I was wondering if you could give me more granularity on what exactly drove the decline in credit losses since that was somewhat counter intuitive, and what it is about those trends you think will either persist or deteriorate in the near-term.

Finally, a quick follow-up on the reside.

Did you indicate exactly how much the IO write-down was in this period?

Let me cover the first part to your question.

And I'll do the second.

The -- I think the lower charge-off rate is consistent with a reduction in our delinquency rates last quarter.

So you saw that we achieved record low delinquencies in -- in May.

And so it would tend to follow that we'd have lower charge-offs during the quarter.

Right, maybe the more appropriate question is why is it that delinquencies continued to decline?

Well, delinquency is -- is up modestly in the third quarter versus the second quarter coming off of that low.

And I think that is consistent with our suggestion that you would expect charge-offs to rise somewhat reflecting the higher delinquency -- the somewhat higher delinquencies of the third quarter.

All right.

Thanks.

Eric, lets me cover that -- that mark question.

I think the -- we actually put on our statistical supplement a line called net gain on securitization.

Okay.

And I -- you know, I think that maybe for the entire audience, you should know that's both volume and rate.

This particular quarter is dominated by a rate reset.

So it's a mark against the embedded asset as opposed to a change in the asset based on volumes of securitization.

And it's shown at $24 million for the quarter.

Good, thank you.

Of a negative -- of a charge.

Thanks.

And the next question comes from the line of Moshe Orenbuch of Credit Suisse.

Please proceed.

I apologize, I got on the line late.

If you did cover this I apologize.

Could you give us some update as to the plans for the network openings kind of outside the U.S.

And then just one clarification after that.

Thanks.

Our primary focus is the U.S., and we're very pleased with our progress there.

We are employing the -- the same Third-Party strategy across the rest of North America so Canada, Mexico, and the Caribbean.

And then opportunistically, we have selectively added acceptance, the leading acceptance in China today, and we've announced a deal with JCB, which eventually will give us Japanese acceptance.

But our focus is primarily North America.

Great.

And just a clarification.

When -- and just a clarification.

When you were talking about the transactions with Chase and Wells Fargo, I think someone had said that the 600,000 and 260,000, that that was based upon new signings of merchants, not the existing ones?

Could you just clarify that.

Well, yes.

And there was actually a third one which was Bank of America.

And those three combined with the previously announced signings brings us to actually agreements with by volume over 90% of the U.S.

acquires of merchants for credit card transactions.

I think someone mentioned 600,000.

I believe that may have been Chase's number of total merchants.

And what -- what you would expect is that roughly three quarters of those merchants are merchants we already have.

And we'll be pursuing the cost synergies and the other roughly one quarter of merchants would be new merchants for Discover when fully rolled out.

And the next question comes from the line of James Ellman with Seacliff.

Please proceed.

Thanks for taking my call.

The question has to do with some of the south side reports that have come out discussing the profit uplift that would likely take place were all the cards to be switched to Visa/Master Card instead of being Discover Cards and potentially closing down the network or selling the network for $1 or that sort.

Can you comment on why that doesn't make sense as parts of your business strategy going forward.

Well, we see great value in our network.

Clearly our Third-Party Payment segment is profitable, and is growing at now 17% year-over-year.

And our network gives us great differentiation by having our brand of point of sale across the U.S.

and online.

And we are very focused on being not just another Master Card/Visa issuer but being a differentiated issuer as well as a payments network owner who participates in both credit and debit, which we think uniquely positions us for growth.

All right.

Well, if that's the case that the network even though it retards earnings right now to have it versus being just another Visa/Master Card owner or issuer, could you comment on the potential value to shareholders were the Company to look to sell itself to one of the big banks, Chase or HSBC or City, in the light that they could then rebrand all of their cards into Discover cards and potentially I would imagine some of the big merchants and maybe Visa or Master Card would be interested in that auction process.

Well, we would not agree that the network ownership retards earnings.

And, in fact, we would say the opposite.

That we believe our prospects, particularly after the Department of Justice suit that opened up the new opportunities to really participate in the Third-Party Payment segment to build scale, to work directly with merchant acquires, to gain full acceptance throughout North America, all these things are things that we think will help us to be able to grow revenues and profits faster than competitors.

I really couldn't comment about potential combinations.

All right.

Thanks for the time.

Thank you.

And the next question comes from the line of Brad Ball with Citigroup.

Please proceed.

Thanks.

A quick follow-up on the IO write-down, Roy.

Is the $24 million that you mentioned, is that a permanent impairment, or do you have the ability to write that back up in future quarters?

Yes, Brad.

It's remarked every quarter.

So, you -- and I'll cite the line to that it resides on.

You can see that there's some volatility in it as you look back over the five quarters we've presented in this statistical supplement.

Some of that is driven by volume.

Some of it is the changing market conditions.

This particular quarter I would say is -- and normally you wouldn't say a dramatic change in it on a mark basis.

The last time we saw these was going back to bankruptcy spike times.

I think in this particular case, with this sort of pinch in the trust -- directly affecting the liabilities of the trust and that's what the mark is based on, you did see a little bit more rate volatility as opposed to volume.

But yes, it goes down and it goes up.

And you can see in the prior-year quarter it went up.

Great.

And separately, I guess more strategically, you had mentioned that in the Third-Party merchant agreements you had some up-front incentives that showed up in the expenses this quarter.

Could you talk about how these incentives are structured.

Are they one-time incentives paid to Chase and Wells and Bank of America or something that you pay on an ongoing basis based on volumes?

And then just finally on this business, how should we evaluate your success in this strategy going forward?

Is it focusing on volume growth, or what are the metrics that you'll provide us with respect to that business?

Well, to answer the second half of the question first, we have -- we are focusing more on gaining share and volume growth right now.

Though certainly we're pleased that we are profitable in the payment segment.

Our primary goal is to achieve 15%-plus transactions growth, and we increase our growths rate this time to 17% as we saw some great opportunities to really step up and gain some market share.

The -- in terms of incentives, and you are talking about the signing of the Third-Parties for PULSE and Discover Network?

Well, maybe I'm confused because you mention in your prepared remarks that you had paid some incentives expenses.

Yes, I guess that is in the Third-Party PULSE, not in the merchant side.

Thank you, yes.

Right.

Okay.

So for Third-Party PULSE and Discover network, what you saw is year-over-year significant growth in transactions with fairly flat revenues.

And so a part of how we were able to -- to accelerate our growth is by having some more aggressive pricing and marketing incentives which normally get amortized over a period of a contract which went against what revenue otherwise might have been.

And so we -- we were pleased by -- to be able to step up and win some of these contracts.

And the success metrics would primarily be growth in transactions and then ultimately growth in revenues, as well.

I guess one thing I would point you to is if you look at the year-to-date metrics for Third-Party Payment segment, it might be more indicative of what our strategy is than taking one particular quarter.

And I think we were up about 22% on transactions year-to-date with an 8% growth in revenue flat expenses, and we were 33% higher in profit before tax for the 9 months year-to-date compared last year.

So we're -- that's -- we're very pleased with that performance.

Great.

Thank you.

And as a reminder, that's star-one for questions.

And the next question comes from the line of Mark Sproule with Thomas Weisel Partners.

Please proceed.

Thanks.

Just a couple of questions.

In the course of the merchant agreements with the likes of Chase and Wells, etc., what's your expectation as the time to sort of fully implement or fully roll into their platforms?

At the time of the road show, we announced that we thought it was about a two-year timeframe.

And given the fact that we've now find 90%, that gives us increased confidence that we will achieve our full objectives, and remain on track.

So the heavy implementation will continue through this year and throughout 2008.

And sometime in 2009, we should be essentially done.

Got you.

And then with the shift in the acquiring model, somewhat subtle, the pricing at least with the -- with your acquiring partners basically in line with sort of a Visa/Master Card model, how is that going to adjust the revenue recognition or the revenue that you'll be able to recognize from transactions on that side, and do you look at that as a real driving point to get a lot of these acquires out there selling your services pretty aggressively?

Well, we think that the largest impact will be increased usage and increased volume growth for both Discover Card and Discover Network Partners.

And as opposed to having a real significant impact on our net effective interchange.

Got you.

And then maybe you can talk me through a little bit more on -- on sort of the stepping stones from a strategic standpoint as you built up a lot of the partnerships to give you the acceptance growth.

And you've obviously seen some incremental signings on the prepaid debit issuance recently.

Where are you in the context of trying to start to compete more aggressively for some of the, maybe larger issuance opportunities as you go forward in the Third-Party side?

Well, we certainly have some significant deals, and I think during the quarter in particular, in debit, we announced some agreements with Bank of America, and with a number of other issuers, including the Cross Bank recently.

And then in Third-Party Signature, GE, HSBC are two of the largest ones that we've announced.

And we have many other smaller ones that we've continued to sign and grow.

And so we -- we are growing at an accelerated pace.

And we think we're growing faster than the industry.

And two detailed questions.

Maybe it's in the supplement and I haven't found it yet.

What was the total accounts that were active and inactive in the quarter?

Could you break that out?

I don't have that at the tip of my hand.

Maybe one other number that I think I got last quarter.

But maybe it was mistaken.

In the non-interest on the management -- manager basis on the non-interest revenue, do you have a breakout of what the merchant card member revenue was?

Yes.

That will be forthcoming in our queue.

Oh, okay.

Thanks, guys.

Thank you.

And the next question comes from the line of Craig Maurer with Calyon Securities.

Please proceed.

Good morning.

Good morning.

Obviously a great quarter from a credit perspective.

But it's hard.

I mean, if you want to talk about the credit business, this -- using a term that's been thrown out recently, monoline credit card business which in this environment would tend to be a lower multiple business.

So I want to focus on the Discover Network for a second, away from PULSE and Third-Party because as you said, there isn't much contribution of profits right now coming from that business.

If you compare what Discover did to what peers did, Master Card and Amex, in the second quarter, which is seasonally a slower quarter considering those months, the Discover Network itself underperformed significantly from a transaction point of view and a dollar volume point of view.

So I was hoping we could talk about that for a minute.

And if there's been any change in the original discussion we had back on your original road show when you had said there was no real interest in changing marketing to improve the view of the network because in my opinion the largest -- one of the biggest issues you have in terms of growing the core network is getting up that percentage of active cards that are using the network, which in my opinion needs to be there to benefit from all the merchant signings you've been discussing.

Thanks.

Well, I look at total network transaction growth, and I think that was 14% year-over-year in the second quarter.

We've increased that to 17% now.

And -- and we don't currently disclose volume.

But typically, average tickets rise.

So typically, you'd see dollar volume grow even faster than that.

And so we think that that compares very favorably to any of the other networks.

And reflects in particular our success in both Third-Party, Signature, which I recognize is not yet broken out, but also in debit which has been -- which has been delighted with how much it's accelerating and the fact that we have moved into a very solid number-three position.

And have done great things since we bought PULSE just 2.5 years ago.

Great.

But as you said, PULSE is not a big contributor right now to profits.

So if you look at the Discover Network transaction volume at 5% growth year-over-year, that growth was significantly behind what a Master Card did x their debit business or an AmEx did.

So it seems that you're still significantly lagging the industry.

Yes.

I'm not -- I'm not sure that I would agree with that.

I would urge you to make sure you look at transactions growth versus volume growth.

No, I -- I am.

Okay.

Well, we're very pleased with the -- the momentum that we've got in both Third-Party Issuance and Discover Network.

As well as debit.

And we think the new strategy with Third-Party acquires to broaden our acceptance will help both Discover Card and our Network business to be -- to grow even faster in the future.

Okay.

Thanks.

And that concludes the Q&A portion of the call.

I'd like to turn it back to Mr.

Stream, Vice President of Investor Relations for closing arguments.

Thanks, Mike.

Just wanted to thank you all for your participation this morning.

And for your interest.

And encourage you to feel free to come back to with us any follow-up questions.

Thanks, and have a good day.

Ladies and gentlemen, this does conclude the presentation.

You may now disconnect.

Thank you very much for your attendance today.

Good afternoon.